Effectiveness for Improving lives

Cost-Benefit Analysis

The estimation of benefits is what separates CBA and CEA and the analysis presented here requires explicitly noting all of the benefits to be included in the analysis as well as the monetary values of those benefits. All relevant project benefits should be noted. Since a societal perspective is taken in CBA for Bank funded projects, the benefits should include all societal benefits.

CHOOSING THE METHOD

The choice of method will depend on many factors.

The critical factors are four:

First

Whether a market exists or does not for the goods and services to be provided by the project. If there is a market, price can be elicited directly from published sources or from direct observation. If not, price information will have to be derived from either revealed or stated preferences.

Second

The nature of the Theory of Change. The logic of the intervention and the identified pathways through which the proposed intervention brings the expected impact are central in identifying the mechanisms by which those impacts can be monetized. A credible transition from outputs to outcomes and impacts will hinge on the quality of the assumptions embedded in the Theory of Change and this sequence and logic needs to be consistent with the step required to monetize impacts.

Third

The quality, availability and timeliness (how recent it is?) of the information/data required for benefit estimation.

There are different approaches in identifying costs including the ingredient method which relies on the identification of all resources or ingredients consumed in an intervention and the valuation of each ingredient. The specification of ingredients is often facilitated by dividing ingredients into categories including 1) personnel, 2) facilities, 3) equipment and materials, 4) other program inputs, and 5) beneficiary or client inputs.

For Bank-funded projects, public sector costs are identified in project documents and the ingredient method is most useful in identifying other costs such as operation and maintenance costs and non-public sector societal costs.

Note: Sunk Costs

Identifying costs in the project

Here are some of the costs the project must identify:

First: public sector costs included for the project investments

Project documents lay out investments and non-recurring costs explicitly as part of project preparation and there should be consistency between what is noted in the project and what is identified as project costs, including costs that are part of the loan as well as counterpart costs.

Second: additional operational and maintenance costs or other recurring costs to the public sector

If the project establishes new government entities or invests in new infrastructure that requires funds for operation and maintenance or other recurring costs beyond the project timeframe these should be included. These are incremental costs beyond what would have been paid for in operation and maintenance without the project.

Third: costs to society that should be incorporated - non-governmental organizations, firms, households or individuals

Any additional costs to non-public entities that result from the project should be included. In general, all inputs (costs) that contribute to the generation of benefits should be included. Otherwise benefits would have to be adjusted accordingly. These costs depend largely on the project and linked to the response required by project beneficiaries to obtain the benefit of the project.

Fourth: total flows of costs in the project

All types of costs should be noted and aggregated to get the total cost flows and the present value of those costs flows. It should be clear that all of these costs are incremental and the manner in which they are measured should be transparent. In the case of shared or common costs (with other projects or among components), these should be distributed and assigned according to a clear allocation rule, which needs to be explicitly stated in the assumptions section.

Once costs and benefits have been identified and valued, alternatives need to be assessed based on an appropriate decision criterion. There are three main criteria:

Net Present Value

Net Present Value (NPV) compares all costs with benefits, with all resource flows discounted by the appropriate discount rate. This comparison is presented in net present value terms typically the current year. If positive, the project should be accepted, if negative rejected on economic merit. The alternative/project with the highest NPV should be selected.

Benefit-Cost (Or Cost-Benefit) Ratio

The Benefit-Cost Ratio (BCR) is the ratio of the sum of benefits (in present value) to the sum of costs (in present value). Typically if this ratio is more than one, using this criterion the project would be approved.

Economic Rate of Return

The Economic Rate of Return (ERR) is defined as the discount rate that causes the NPV to be zero. Typically if the ERR is larger than the recommended 12% real discount rate the project would be approved.

In practice, it is helpful to compute and present all three criteria. The computation of the ERR is required and should be reported. Neither the ERR nor the BCR provide any indication of the project scale so presenting the NPV is desirable. Based on the presentation of results using the chosen investment criteria, an initial conclusion should be drawn on the viability of the project.

Sensitivity analysis allows the testing, under different scenarios, of the strength and robustness of the assumptions, the data and the logic of the intervention that underlie the economic analysis and to acknowledge the underlying uncertainty of the expected results. Any forward looking estimation presumes behavioral assumptions, assumptions on the vertical logic, and on the causality links that allow the attribution of a particular benefit or cost to the goods and/or services delivered or used by the project.

In addition it is necessary to undertake sensitivity analysis to compensate for the natural tendency for project appraisers to be overly optimistic. Many project parameters are affected by optimism, overstating benefits and understating timings and costs, both capital and operational.

Important Questions to Address

What are the critical drivers and the switching triggers of costs and benefits?

In many instances both costs and benefits are driven by a few critical factors. Identifying these factors – that can be called “drivers” - is a central element in performing a good sensitivity analysis. The assumptions behind the future performance of these drivers need to be critically assessed and the sensitivity analysis can illuminate at which points in these assumptions the project is no longer worth pursuing. These values are typically called “switching values¨.

In a sensitivity analysis, it is important to focus on “what if” situations, particularly in adverse or more stringent and acid scenarios than those assumed under a Base Case scenario. This focus will allow the analysis to illuminate those values in critical variables and assumptions that might “switch” the recommendation from Go to No Go (or vice-versa) or to reformulate project design and / or components in order to make the project viable. As there are many sources of uncertainty and numerous risks, it can be very useful to identify the key sources of uncertainty and base the analysis on those. Sometimes having too much information does not provide guidance as to the viability of the project under different situations.

The sensitivity analysis, which is really a risk assessment, should be coherent with the Risk Matrix and other risks discussed in the project proposal.

Many projects face significant start and implementation delays. If warranted, a simulation should be undertaken delaying start and implementation dates.

In a CBA derived from impact evaluations – sensitivity can be done by ranking alternatives by their relative net benefit indicators (NPV, ERR or C/B) using the point estimate of their impact, and then re-compute this ratio using the lower and upper bounds of the impact estimate.

How "Base" is the base case scenario

A Base Case reflects the most plausible estimates for unknown quantities and prices and should reflect the average expectation on their future behavior, particularly of cost and benefit drivers. This average expected behavior should be empirically based. The more useful sensitivity analysis are those that present few explicit and reasoned changes on the assumptions of the most critical values of the drivers of the dominant benefits and costs, many times in a “best case, worse case” situation.

Are these factors interrelated?

Sensitivity analysis can be “one way” or “multi-way”.

One way sensitivity analysis allows for the variation of one critical variable at a time, holding everything else constant. Some authors call this “partial sensitivity analysis¨. This kind of analysis is most appropriately applied to situation in which the analyst believes there is one critical driver.

Multi-way allows for simultaneous variations of more than one variable at a time. In this type of analysis, variable combinations can be combined into best case and worse case scenarios. Some projects lend themselves to simulations, where combinations of different scenarios and their probability of occurrence can be modeled and estimations of critical values can be synthesized in terms of Expectations or Expected Values. This is typically undertaken with decision trees and Monte Carlo Simulations. In these cases, means and variances con indicate project risk profiles.

In a single factor sensitivity analysis, it is generally assumed that all other factors stay constant. In many projects, this might not be true and the variables might not be independent. In those cases, a discussion on correlation issues is warranted.

How can the project unicertainties and risks be mitigated and how do these mitigation measures affect the project's outcome?

Sensitivity analyses can also help, if the feasibility of a project is very sensitive to a particular assumption on the value of a variable that is uncertain, in identifying mitigating actions that should be considered. If there is exceptional uncertainty, the project might have to be redesigned if implemented on a pilot basis.

Are he projected scenarios empirically based?

Sensitivity analysis is most useful if the proposed scenarios and adjustments are empirically based and/or reflect the unique characteristics of the project in hand—how good and reliable is the data. As with the initial assumptions used in an analysis, ideally the scenarios are empirically based.